The second quarter produced solid economic growth, but there was also important news about revisions to real gross domestic product covering the past three years. The weaker trend in output could have serious implications for productivity and monetary policy.
The Bureau of Economic Analysis released revised data going back to 2004. Real GDP growth was trimmed from an average annual rate of 3.5% to 3.2%, making this year's first-quarter GDP about $120 billion lower than first thought.
One upshot to weaker growth is smaller gains in labor productivity. Taking the new GDP numbers and no change in employment, the revised labor productivity growth released on July 7 would show a troubling reduction in productivity of about 0.3% to 0.4% per year, says Credit Suisse Group (CS) chief economist Neal Soss.
Throw in the BEA's small upward revisions to inflation during the past three years, and it looks quite clear that the pace at which the economy can grow without whipping up price pressures is not as high as previously thought. Soss now thinks the economy can grow only 2.75%, instead of 3%, without stirring inflation. Other economists believe the pace is even lower.
A slower speed limit could make life trickier for the central bank. While it is responsible for keeping inflation low and stable, "the Fed's first mandate is ensuring financial stability," says Soss.
In its July Monetary Policy Report to the Congress, the Fed's economic projections imply real GDP growth of 2.5% to 3% in the second half of 2007. Growth at the upper end of this range would likely spur stronger hiring, wage gains, and inflation.
Chairman Ben S. Bernanke must be mindful of the potential impact a change in interest rates could have on jumpy financial markets and the rate-sensitive housing sector. What's more, the Fed may now have less leeway to cut rates if conditions worsen in financial markets. Adding up the risks, the central bankers may feel compelled to keep rates where they are for a long time.
By James Mehring